Fiscal Policy, Business Cycles and Economic Stabilisation: Evidence from Industrialised and Developing Countries

This paper empirically investigates the responsiveness of fiscal policy to business cycles and the effectiveness of fiscal policy in reducing economic fluctuations. From regressions on the responsiveness of fiscal policy to business cycles, we find that the government's current expenditures and subsidies & transfers move counter-cyclically, whereas taxes and capital expenditures move pro-cyclically. Using economic fluctuations in neighbouring countries as an instrumental variable, we show that ordinary least squares (OLS) estimates understate the responsiveness of fiscal policy to economic fluctuations. We also find that fiscal policy responds asymmetrically over economic fluctuations. In investigating the effectiveness of fiscal policy in reducing economic fluctuations, we mitigate omitted variable bias by adding four important factors - military expenditures, oil production, economic fluctuations in neighbouring countries and fiscal policy responsiveness to business cycles. The results of effectiveness regressions are consistent with the responsiveness regressions, highlighting the importance of current expenditures, especially subsidies and transfers, in responding to business cycles and stabilising the economy. Copyright 2007 Institute for Fiscal Studies.